Do Tax Cuts and Trickle Down Economics Work for America?

Do tax cuts lead to robust economic growth and greater prosperity for all? According to trickle down economics the answer is in the affirmative. Trickle down economics, often identified with supply side economics, represents the idea that tax cuts or other government sponsored interventions into the economy to help businesses and the wealthy will benefit poorer members of society by improving the economy as a whole. It should be noted that in the application of the theory the wealthy tend to benefit more from the tax cuts than the rest of the population.

Actually, if this worked I would be totally in favor of such an economic policy. It would appear to be an excellent balance for a robust capitalist system with one that desires certain levels of economic justice, rewarding job creators for their risk-taking and providing shared, albeit smaller but fairer, returns to the the masses who help the job creators become successful. Unfortunately, the evidence doesn’t support trickle down, supply side economics.

The evidence to answer the question comes primarily from two great experiments during the Reagan and G.W. Bush eras. Both administrations aggressively pursued tax cuts, favoring the wealthy, with the view that forecasted benefits associated with economic growth would trickle down to the masses.

The Evidence

Historical evidence demonstrates the United States has had some of its strongest periods of economic growth while taxes were high. As the following graph shows, some of our most robust periods of growth in gross domestic product (GDP) actually occurred while taxes were very high:

During the 1950s the USA experienced some of the sharpest periods of economic growth with the top marginal tax rates for the richest Americans above 90 percent! Marginal tax rates were adjusted upward in the 1990s, again with strong economic growth.

If trickle down economic tax cuts worked Bush should have had a great economic record

The Bush tax cuts never trickled down

If trickle down economics worked we should observe growing real median income for the population as a whole. Despite huge tax cuts the desired trickle down outcome did not come to fruition for the majority of Americans, per the following figure.

Median household income grew marginally from 1967 to 2010, despite the massive injection of women into the workforce to sustain a desired quality of life, and huge tax cuts in the 1980s and 2000s. Nor do we see trickle down economics at work from this Congressional Budget Office chart, with more details in a previous post.

The above figure shows the share of market income for every quintile, except the highest quintile, declined 1979 to 2007, as revealed by my arrows added to the CBO graph. If trickle down effects worked as proclaimed then the share of market income should be greater for each quintile in 2007 when compared to 1979, the years prior to the implementation of the Reagan and Bush era tax cuts.

The CBO also produced the data I used to produce the following graph, depicting percent share of pre-tax income by quintile, 1979-2005.

From Economic Policy Institute: The Bush economic expansion had the worst wage and salary growth and total compensation growth of any postwar economic expansion. Workers also fared progressively worse the lower they were in the income distribution.

Inflation-adjusted median weekly earnings fell by 2.3% during the economic expansion from 2001Q4 to 2007Q4.1 Over this same period, nonfarm business productivity (output per hours worked) increased 15.4%; 2 in essence, wage growth became further decoupled from productivity growth.

Between 2002 and 2007, real hourly earnings fell 1.7% for men in the bottom 10th percentile of wage earnings, fell 0.4% for men in the 50th wage percentile, and increased 2.4% for men in the 90th wage percentile, continuing a trend of very uneven wage growth.3

The bottom 90% of earners were left with just 13% of total income gains, significantly less income than the 24% captured by the top 0.01% (those with incomes above $9.5 million).4

Total employment increased just 0.9% annually—one-third of the average growth in postwar economic expansions—just barely keeping pace with population growth. The 2002-2007 expansion was the only postwar expansion in which the employment-to-population ratio did not rise.5

The national unemployment rate never once returned to pre-recession levels.6

The fallacy that Bush tax cuts would pay for itself through economic growth was exposed by a report issued under the supervision of a supply-side economist handpicked by the White House and published by the CBO. It concluded the president’s budget would make long-term budget deficits worse rather than better.

The Wall Street Journal, at the time an advocate for supply-side economics, and the source of dozens of columns and editorials demanding dynamic scoring to reflect the “true” impact of big tax cuts, examined the results of various CBO models and concluded, “… in every case, the effects are relatively small. And in no case does Mr. Bush’s tax cut come close to paying for itself over the next 10 years.”

Moody’s Analytics Chief Economist Mark Zandi estimates that making the Bush income tax cuts permanent would currently generate only 35 cents in economic activity for every dollar in forgone revenue.7

Unfortunately for the middle class Bush tax cuts and trickle down economic theory didn’t produce strong economic growth, as measured by employment and GDP growth, per the following analysis from the Center on Budget and Policy Priorities:8

If the massive Bush tax cuts worked to create a more prosperous economy President Bush should be regarded as one of the greatest economic growth Presidents in modern times. Just the opposite occurred as explained by the conservative Wall Street Journal.

Bush’s record indicates his administration produced only 375,000 jobs per year in office, just beating Hoover’s record. The Wall Street Journal provides an appropriate summary,

“The current President Bush, once taking account how long he’s been in office, shows the worst track record for job creation since the government began keeping records.”

Between the end of the 2001 recession (2001Q4) and the peak of that expansion (2007Q4), the U.S. economy experienced the worst economic expansion of the post-war era.9

Growth in investment, GDP, and employment all posted their worst performance of any post-war expansion.10

The tax cuts were supposed to encourage business investment, but nonresidential fixed investment increased a meager 2.1% annually—a third of the average increase and less than half that of the next poorest post-war increase in business investment on record.

While the promised jobs and GDP growth failed to come to fruition the cost of the budget-busting 2001 and 2003 tax cuts was, as estimated by Citizens for Tax Justice, roughly $2.5 trillion through 2010.

Ezra Klein provides a more current update:

“The new CBO data show that changes in law enacted since January 2001 increased the deficit by $539 billion in 2005. In the absence of such legislation, the nation would have a surplus this year. Tax cuts account for almost half — 48 percent — of this $539 billion in increased costs. How about the Committee for a Responsible Federal Budget? Their budget calculator shows that the tax cuts will cost $3.28 trillion between 2011 and 2018. This evidence was a tremendous blow to trickle-down/supply side economics.

Making the changes permanent would cost about $4.6 trillion over the 2012-21 period.11

The extension of the Bush tax cuts in the December 2010 tax deal is projected to decrease revenue by $423 billion over 2012-21, pushing the total cost above $5.0 trillion over the next decade.12 This represents about half of the total projected deficits over this period.13

Just allowing the Bush tax cuts to expire would put public debt on a sustainable trajectory over the next decade, maintaining a constant share of the economy through the entire 10-year period.14

The opportunity cost of the Bush tax cuts is significant. If continued, they will crowd out budget priorities such as economic security programs and investments in education, infrastructure, research, and health.

More evidence against supply side, trickle down economics: The Reagan Era

The Bush era wasn’t the first time supply side economics failed. The usual narrative is that Reagan’s huge tax cuts resulted in extraordinary economic growth. The problem is the facts don’t match the narrative. Here’s a graph by Mike Kimel, reflecting the actual historic facts:

Kimel summarizes his findings:

“Yes, there was a tax cut and the economy started growing. But the only growth that was unusually strong for the time period occurred in one single year, from 1983 to 1984. And immediately afterwards it dropped and kept dropping. In 1987, there was a small pickup in growth which accompanied a further tax cut (50% to 38.5%), but the year after, when the top marginal tax rate dropped further (to 28%), growth fell again.

Strip away the rhetoric, and it would seem the “evidence” for the benefits of Reaganomics, for the most part, are that following the small tax cut in 1981 (70% to 69.25%) and the bigger one in 1982 (69.25% to 50%), there was one seemingly extraordinary year of growth from 1983 to 1984.”

Kimel’s analysis of the relationship between real GDP growth and tax rates during 1981-1993 is illuminating, per the following figure.

Quoting Kimel again,

“It goes without saying that what the graph does not, repeat, does not show is that lower tax rates have much to do with faster economic growth. In fact, some of the slowest sustained economic “growth” that occurred during the Reagan-Bush years coincided with the lowest tax rates: 28% and 31%. The one standout year occurred when tax rates were at 50%, and had been at 50% for a few years. And yet, somehow this period has entered the public consciousness as Exhibit A that Tax Cuts Work.”

After a bit more analysis Kimel adds,

“If you’re wondering, during seven of the 12 Reagan-Bush years, growth rates were actually below the average rate observed when top marginal tax rates were above 90%… and the really slow growth during the Reagan – Bush era occurred disproportionately when tax rates were at the 28% and 31%. That is to say, when tax rates were at their lowest levels in the Reagan – Bush era, growth rates were also at their lowest. And as the graph also shows, every single year, repeat, every single year of the Reagan Bush had a lower average growth rate than when tax rates were in the 60% to 69.9% range.”

There is also the question relating to the effect of Reagan tax cuts on federal revenue. Supply side economics argues in the long term tax cuts will expand the tax base, yielding more federal revenue. As Paul Krugman, a Nobel winning economist, observes after studying Reagan’s application of supply-side economics,

Krugman continues,

This is exactly what you would expect to see if supply-side economics were just plain wrong: revenues are permanently reduced relative to what they would otherwise have been.

Conclusion

Did wealth trickle down from the rich to the poor as a result of tax cuts designed to produce robust economic growth? The succinct answer is simply no. There’s too much evidence against the theory. Trickle down economics is more of an ideology, utilized to promote an agenda.

4 Saez, Emmanuel. 2010. University of California, Berkeley: http://www.econ.berkeley.edu/~saez/TabFig2008.xls. Income cutoffs for percentile distributions have been adjusted from 2008 dollars to April 2011 dollars (CPI-U-RS).

12 Joint Committee on Taxation. 2010. “Estimated Budget Effects of the “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010.” http://www.jct.gov/publications.html?func=startdown&id=3715 This reflects the cost of individual income tax cuts, the AMT patch, and the reinstatement of the estate tax at a $5 million exemption and 35% rate.

13 EPI calculations based on CBO’s “Budget and Economic Outlook: Fiscal Years 2011 to 2021” and “An Analysis of the President’s Budgetary Proposals for Fiscal Year 2012.” Projected current policy deficits are based on CBO’s March 2011 baseline, adjusted for continuation of the 2001 and 2003 tax cuts, the AMT patch, the doc fix (maintaining Medicare physician payment rates), and the overseas contingency operation funding estimates in the president’s 2012 budget request.

5 Responses to Do Tax Cuts and Trickle Down Economics Work for America?

Great work Dr. Morrison! It is a sad day that the Republican Party as a whole has chosen to support the interests of the 1% over the interests of the middle class. And it is a sadder day that still too many in the middle class believe the deception that is originating from folks like the Koch Brothers.

Jobs can easily return to the USA if the tax incentives sending them out of the country were eliminated and instead, a penalty imposed on sending those jobs outside of the U.S. Yet no one talks about this, not even the D’s who stand to benefit by promoting a change in our tax policies by bringing back jobs to the United States.

It is a sad day indeed that greed and money has priority over the well being of the middle and lower classes.

Finally, doesn’t Corporate America understand if there is little or no discressionary income, sales of their corporate products will continue to also diminish in proportion, thus eventually the corporations will have little or no profits?

I’m not sure how that would work. First, it’s difficult to identify a good metric for corporate or individual greed. Without good measurement empirical analysis is not possible. it’s then just a guessing game, although one could hold out for qualitative studies which have vastly improved over time.

There are some issues here in this article. First you seem to assume that taxes are the sole carrier of the economy and then saying that just because the economy didn’t do well during that era of tax cuts it’s automatically the 100% due to the tax cuts.

Second, you make the assumption that tax cuts only help the rich, now while I can’t speak for the Bush tax cuts as I’m not too familiar with them, the Reagan 1986 reform actually INCREASED the tax burden on the richest americans while other quintiles either saw very little change in their burden or less burden overall.

Third, although I’m not too familiar with the Bush era economy, I do know that he experienced two economic downturns one from the end of the Clinton era in 00 and 01 or so, and then the worst economic downturn to ever be seen since the great depression, is this taken into effect? If so how?

Fourth, you make the argument that we’re doing very well when the top marginal rates were at 90%, however it’s pretty well argued that while the top rate was 90% the effective rate was about 60% or so. Then if you add other factors in there it makes sense like for example WW2, pretty much everyone was still recovering from the war throughout the 40’s, 50’s, 60’s and 70’s while America was practically untouched. This has to be taken into account as American goods were more or less the only type of goods. You also pointed to growth under Clinton, however again you only looked at income tax, and while it’s true the top income tax rate went up to 30% or so it’s irresponsible to credit the growth of the 90’s solely to that tax rate. For example in 96 or so Clinton CUT the top Capital Gains tax, and once that was in place we saw better growth than when Bush Sr. raised taxes and even when Clinton raised the marginal income tax rates. Then add the fact that factors outside of government were also in motion like the internet boom, the creation of the internet sparked incredible growth for sure, however it should also be noted that despite the boom GDP grew on average better during the Reagan years than during the Clinton years.

These are just a few issues I’ve found, if you see flaws in my observation of this article then fine please point them out. If you like I’ll try to find all the links and whatnot that support my claims here, it’s up to you.